Among the changes made by the recently enacted Bipartisan Budget Act of 2015 is a complete rewrite of the partnership audit rules. The new rules, which take effect in 2018 (for tax years beginning after 2017), will have a big impact on many partnerships — particularly hedge funds, private equity funds, and other investment partnerships.
The new rules are intended to shift many burdens associated with the audit process from the IRS to partnerships, which will likely result in a significant increase in the number of partnership audits. In addition, by allowing the IRS to audit and collect tax from partnerships at the entity level, the new rules will, in some cases, create unwelcome economic outcomes for investors. However, there are steps partnerships can take to mitigate such outcomes.
Addressing Administrative Burdens
Current partnership audit rules were established under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Under these rules, which apply to all partnerships with more than 10 partners (all of which are either individuals, estates of deceased partners, or C corporations), the IRS assesses and collects tax at the individual partner level. Although current law provides simplified audit procedures for “electing large partnerships” (those with 100 or more partners), very few partnerships make the election.
Not surprisingly, the need to assess audit adjustments against individual partners places a significant administrative burden on the IRS, especially when large partnerships are involved. According to the Government Accountability Office (GAO), in 2014 the IRS audited less than 1% of 2012 income tax returns filed by partnerships with more than $100 million in assets. In contrast, the audit rate for large C corporations — for which tax is assessed and collected at the entity level — was more than 27%.
The new rules are designed to streamline the audit process and increase the number of audits by allowing the IRS to assess and collect taxes, penalties, and interest at the partnership level.
Making Income Adjustments
Under the new rules, when the IRS audits a partnership, it will determine any adjustments to the partnership’s items of income, gain, loss, deduction, or credit (and to partners’ distributive shares of those items) and assess any additional taxes (plus interest and penalties) at the partnership level. The partnership’s tax liability is determined by multiplying the net adjustment by the highest marginal individual federal income tax rate for the year under review (currently, 39.6%).
This “imputed underpayment” is taken into account in the adjustment year — the year in which the final determination is made. Similarly, an adjustment that results in a net reduction in income is taken into account by the partnership in the adjustment year rather than in the year under review.
Although the new rules make the audit process easier for the IRS, they potentially create inequitable results for partnerships and their partners. For example:
- A partnership’s current partners might bear the cost of a tax assessment, or enjoy the benefits of a tax reduction, regardless of whether they were partners during the year under review.
- Applying the highest marginal tax rate to an imputed underpayment deprives the partnership of the benefit of partner-level tax attributes that would otherwise reduce the tax liability.
- When an audit results in reallocation of income among partners, the adjustment is based on the increase in income to one partner or group of partners without a corresponding reduction in the other partners’ income.
Also, the new rules replace the “tax matters partner” with a “partnership representative.” The representative doesn’t have to be a partner, but must have a substantial U.S. presence. This representative will have broad authority to bind the partnership and its partners in dealings with the IRS. Once the new rules take effect, partners will lose their statutory rights to receive notices regarding audit proceedings or to participate in them.
Mitigating the Effects
Fortunately, partnerships can reduce the impact of the new audit rules. First, partnerships with 100 or fewer qualifying partners may avoid the new rules altogether by filing an annual “small partnership election.” The election is available only to partnerships whose partners are individuals, corporations, or estates. For S corporation partners, each shareholder counts toward the 100-partner threshold. Partnerships are not qualifying partners so tiered partnerships, including many investment funds, are ineligible for the election.
Partnerships that are subject to the new rules may be able to mitigate their effects by requiring those investors who were partners during the year under review file amended returns for that year and pay their share of any tax deficiency. Additionally, the partnership may reduce the imputed underpayment by demonstrating that a portion of the adjustment is allocable to:
- Tax-exempt partners,
- Income taxed at lower rates, such as capital gains or qualified dividends, or
- Partners taxed at rates lower than the highest individual rate, such as C corporations.
Partnerships may also want to make an election (within 45 days after the audit is complete) to provide its partners who were partners during the year under review with adjusted K-1s reporting their allocable share of any partnership-level audit adjustments. These partners would be assessed additional tax plus penalties (interest rate would be 2% higher than the regular underpayment rate). The partnership needs to furnish the IRS with a statement that details each partner’s share of the audit adjustments.
Although the new partnership audit rules don’t take effect until after Dec. 31, 2017, you should begin reviewing the changes now to assess their potential impact, keeping in mind that new regulations may clarify or even change these rules.
- Does our partnership qualify for the small partnership election and, if not, should we change its structure to qualify?
- Should we elect any of the options described above to mitigate the effects of the new rules?
- Should our partners be required to take certain actions? (For example, should the partners from the year under review be required to file amended returns?)
- How should we allocate the assessment among our partners?
- Who should be our representative and should we revise our partnership documents to limit or expand the representative’s authority?
- If the partnership elects to apply the adjusted K-1 rules in the event the partnership receives a notice of final partnership adjustment, what should be addressed in the partnership agreement in regards to the partner’s capital accounts.
- In the event that the partnership could not mitigate the partnership level tax, should the agreement address the reserves for the cost of dealing with IRS audits?
- If entities are currently eligible for exemption, should the entities consider restrictions when admitting new partners that would jeopardize that status and specify such in the subscription documents?
- What information should be provided to the partners when the partnership makes certain elections or “opts out” of the elections?
- Since the assessment could be at the partnership level, financial statement auditors may need to consider uncertain tax positions taken by the partnership in prior years that could give rise to the need for a FIN48 reserve.
Once you’ve developed a strategy for addressing the new rules, you’ll need to amend your operating agreements, offering memoranda, subscription agreements, and other fund documents to ensure that appropriate actions are taken and that the potential impact of the new rules is disclosed to investors. For assistance with what can be a complicated process, please contact your Untracht Early advisor.